Why do gas pump prices rise faster than costs?

MSNBC.com answers your questions on business, personal finance

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The continued surge in gasoline prices — and President Bush's speech this week offering relief — touched off a flood of mail from readers. Many, like Chad in Massachusetts, are having a hard time understanding why pump prices seem to have no relationship to the cost of producing the gas in the first place.

Why isn't there a law that states it is illegal to raise gas prices while X number of gallons of gas are still currently in the pumps? The gas that I am getting out of the pumps at a given station is the same gas that was put in there last week at a different cost. There is nothing that could happen to make those stations pay more for what they all ready have so why should I be paying more for it?
—Chad M., Easthampton, Mass.

Setting aside the problem of separating multiple deliveries sloshing around in an underground tank, the price at the pump is not determined by how much the retailer or wholesaler paid for the gas. The market price of any commodity is the price a willing buyer and a willing seller voluntarily agree to. You may be an extremely angry, frustrated, cash-strapped driver who needs to get to work, but you’re still a willing buyer when you pull up to the pump.

This is the part that many readers have trouble with: the market price of a given commodity has nothing to do with cost of producing it. If I want to buy an ounce of gold today, I’ll have to pay $650. That ounce of gold may have been mined yesterday, or a year ago, or 100 years ago — it doesn’t matter. If the market price of one ounce of gold goes to $650, so does the price of every ounce, even if it has been sitting in a vault since it was produced at a much lower cost.

A farmer can’t add up the cost of growing corn, tack on a 10 percent profit, and tell buyers, “This is what my corn costs.” The market tells him, “This is what you’ll get for your corn.” In the days before farm subsidies, farming could be a terrible way to make a living. If a crop failed in a given year, the shortage would drive up prices but you might have little, if anything, to sell. If you brought in a bumper crop the next year, the glut would pull prices down sharply: You might have lots of corn, but you wouldn’t get much for it. Futures markets were developed to take some of that risk off the farmer's shoulders.

Today, farmers are guaranteed a minimum price because our government believes it’s in the nation’s best interest to keep U.S. farms in business and maintain our own food supplies. That and the ongoing efforts of a huge farm lobby that ensures Congress protects those subsidies.

In the case of oil, some buyers are end users, and others are speculators. Some sellers are companies that actually invested the money to hire a rig to go drill for the oil. Others are speculators who bought a futures contract — or even physical oil — betting that the market price would go higher and they would make money. True, when the market gets “nervous” it often adds a premium to a price that might not otherwise be there. The same is true on the flip side: when traders fear a glut, they may “oversell,” forcing prices lower than they might otherwise go. That’s what happened as recently as 1998 when oil prices crashed to $12 a barrel.

Without a global futures market, you would see even bigger, more frequent price spikes and crashes. Companies couldn’t protect themselves from higher prices by locking in delivery well into the future. Producers couldn’t invest in expanding production with any confidence they’d get back that investment.

History is littered with painful commodity booms and busts that happened before modern futures markets were set up. So the “premium” we all pay to the investors who buy and sell purely for profit is the cost of the market mechanism that brings some order to pricing. It’s money well spent.

Your article about gas prices makes the future sound pretty bleak. Is there any correct way to fix this? ... What do you think the solution to this problem is? Please respond to that question at least.
—Timothy H., Fairborn, Ohio

The answer is that at some point very soon, the global oil market will have to "rebalance" itself. We may well be in the early stages of this now. What that means is that if demand keeps growing, and production can't keep up (as now seems inevitable), prices will rise until those high prices stop the growth in demand.

One way that could happen is if the high cost of energy begins to slow the global economy. The impact of such a slowdown may not be evenly felt. In 1998, smaller Asian economies were badly hurt by recession while the U.S. economy suffered much less.

If the global economy — or big parts of it — enter recession, demand for oil should ease up. That will take pressure off prices. This is what happened last time around when oil prices crashed in 1998. Prices fell so far so fast that oil companies found it cheaper to buy each other up than to invest in drilling for new oil. That's why we have so few private oil companies today. The government went along with these mergers, in part, because oil was so cheap.

To avoid a global recession, we're going to have to figure out how to continue to get more out of each barrel of oil — through increased efficiency, conservation, or whatever you want to call it. It worked after the last oil price spikes in the 1970s: it now takes about half as much oil to produce each every dollar of U.S. gross domestic product as it did 30 years ago.

Alas, the Congress and White House have done little to promote conservation. When Vice President Cheney chaired the original energy task force he pointedly said that while conservation may be “a personal virtue” it has no place in national energy policy.

If oil prices continue to rise above, say, $100 a barrel, that likely will change. You'll see more carpooling and mass transit will become more popular. You'll also see a lot more working from home by people who now drive to an office to sit in a sea of cubicles and stare at a computer screen, which they can now do via high-speed Internet from their living room. Air travel will get more costly (after several airlines go out of business, allowing the remaining carriers to raise prices.) Ordering online will get more expensive as shipping costs go up.

In any case, unless some other way is found to power our global economy — and fairly quickly — it's likely that oil prices will continue to rise. Those alternatives (like wind, solar, etc.) are growing rapidly but make up only a very small fraction of overall energy supply. And no one has yet come up with a substitute for petroleum as a transportation fuel. Gas-electric hybrids are an important step, but it will be years before the 200+ million gas-powered cars in the United States alone are replaced by more efficient vehicles.

It's not inevitable that the "rebalancing" is painful, but there's certainly a major risk that it becomes so. Based on the recent actions of our government, and the current status of various private initiatives to develop alternatives and promote conservation, things aren't looking great at the moment.

Wouldn't nationalizing oil make prices stabilize?
—John S. Milwaukee

No. Oil is a global commodity, so nationalizing production in one country would have no impact on worldwide supply and demand. It might even hurt if it meant less money was available in profits to invest in finding and developing new supplies and expanding production.

The U.S. government could take steps to cut gasoline taxes, or subsidize retail pump prices. With the federal budget already hundreds of billions of dollar in the red, it's hard to see where that money would come from without getting us further into debt. But the government doesn’t need to take over an industry to subsidize it.